US fiscal outlook set to come into focus

USD: Fiscal uncertainties to add to trade policy uncertainties

US dollar selling faded in the afternoon yesterday as yields in the US drifted higher confirming the continued positive momentum of higher yields. The 2-year UST note yield hit the highest level since March prior to the reciprocal tariff announcement and market volatility in April. There was no US data of note to drive yields higher but the move higher could have been partly helped by the news that the Republican tax bill is advancing in Congress. Yesterday, the bill was passed by the House Ways and Means Committee with a vote along party lines. The bill essentially makes permanent the 2017 tax cuts and adds to the that eliminating tax on tips and overtime pay plus additional tax deductions for seniors and auto buyers (interest rate tax deductions). Those additional elements will expire in 2028. Trump’s apparent consideration to raise the 37% tax rate on the very wealthy was not included.

The bi-partisan Joint Committee on Taxation, in a detailed 10-page document released on Tuesday estimated that the legislation would add USD 3.8trn to US debt levels over a 10-year period to 2034. The legislation if passed in its current format is going to ensure that US fiscal deficits continue to run at unsustainable levels over 6% of GDP. The IMF Fiscal Monitor released just last month revealed US fiscal deficits would drop from 7.3% last year to 6.5% this year and drop further to 5.4% in 2027 before then rising to between 5.5% and 5.6% in the three years following to 2030. These projections were based on current legislation and with the tax bill in its current format would mean these deficits are even higher.

There remain some issues to resolve before the bill goes to a vote like the SALT tax deduction cap, currently at USD 10k but could rise to USD 30k. Some Republicans want a higher limit. Spending cuts to still be agreed can take down the overall impact on deficits but cuts will get nowhere close to funding this tax bill. The plan once the smaller issues are agreed is for the House to vote next week with an aim to have it agreed between the House and Senate and ready for Trump’s signature by 4^th July.

But this bill could get bogged down in the Senate and then could be drawn into the issue of agreeing an extension to the debt ceiling. The Bipartisan Policy Center estimates the so-called x-date, when the government will exhaust all means of funding government expenditure (US debt is currently at the ceiling limit of USD 36.1trn), will arrive at some point between August and October.

Can the US Treasury market continue to absorb increased supply and apparent indifference to rising deficits by the Trump administration? Much of the cost of this bill is merely to extend the status quo and other aspects could easily be crowded out by yields being higher than otherwise would be. That in our view means this development will not prove positive for the dollar. The x-date uncertainty could well also coincide with renewed trade uncertainty given the expiring reciprocal tariffs period in July and for China in August.

US FISCAL DEFICIT PROJECTIONS FROM IMF – THE LARGEST DEFICITS AMONGST KEY COUNTRIES

Source: Bloomberg, Macrobond & MUFG GMR

GBP: More positive data to provide pound support

Based on the BoE’s trade-weighted index, the pound this week returned close to the highs seen toward the end of April, which were the strongest levels for the pound since the Brexit referendum in 2016. The recent run of economic data has been positive for the pound although the labour market data this week was mixed – with wage growth still indicating stickiness at levels not consistent with the BoE’s inflation target but employment clearly showing a continued weakening trend.

There was a deluge of economic data releases this morning and the GDP data was stronger than expected with consumer spending weakness more than offset by very strong business investment. Consumer spending grew just 0.2% Q/Q but business investment surged 5.9% Q/Q, the strongest reading since Q1 2023. If you exclude the volatile period during and just after covid, the business investment growth over a two-quarter period was the strongest since before the Brexit vote in Q3-Q4 2015. The momentum in GDP was also positive with the m/m March reading increasing 0.2% versus an expected 0.0% reading. Services activity in March was much stronger than expected.

The primary note of caution in the data is that business investment is a volatile component and the growth in Q1 was very much down to business investment, which contributed 0.58ppts of the 0.7% overall GDP gain. That will likely mean investors remain cautious over reading too much into the Q1 data. Net trade added a further 0.36ppt that may have been in part down to exports being brought forward due to trade policy uncertainties. Given what happened in April, the BoE views risks to growth to the downside and hence the BoE is unlikely to alter its current policy plans that remain consistent with one 25bp cut per quarter.

We would still expect front-end rates in the UK to tick a little higher when open which will help provide some moderate support for the pound. But EUR/GBP is flat suggesting the cautious interpretation of the data. EUR/GBP has ticked a little higher this week but we see no reason for this to extend much over the short-term given the reasonably positive data released today.  

ELEVATED SPECULATIVE LONG GBP POSITIONS WILL LIMIT GBP UPSIDE FOLLOWING UK GDP DATA

Source: Bloomberg, Macrobond & MUFG GMR

KEY RELEASES AND EVENTS

Source: Bloomberg & Investing.com